American & Exotic Options

Lorenzo Bretscher
American Options

An American option is like a European option except that it can be exercised

at any time prior to maturity

We can price American options using the binomial model

I We work backwards from the final period
I At each node, we need to check whether early exercise is optimal

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American Call: A Two-Period Example

Consider an American call with strike price K = $55 and maturity six months.
Suppose that every three months the underlying stock goes either up by 20% or
down by 10%. The stock price today is $50 and the three-month interest rate is
1.25%

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Early Exercise of an American Call

Early exercise is optimal if the price of the call is less than the payoff obtained
from exercising
In our example:
I u-node: 6.30 > 5 ⇒ Do not exercise
I d-node: 0 > −10 ⇒ Do not exercise
Therefore, early exercise is not optimal
Theorem: It is never optimal to exercise early an American call on a
non-dividend paying stock

C Am ≥ C Eu = P + S − PV (K ) > P + S − K ≥ S − K

⇒ C Am > S − K , which is the value of immediate exercise

Hence, the price of an American call on a non-dividend paying stock is the
same as the price of the corresponding European call

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American Put: A Two-Period Example

Consider an American put with strike price K = $55 and maturity six months.
Suppose that every three months the underlying stock goes either up by 20% or
down by 10%. The stock price today is $50 and the three-month interest rate is
1.25%.

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Early Exercise of an American Put

Early exercise is optimal if the price of the European put is less than the payoff
obtained from exercising.
In our example:
I u-node: 0.62 > −5 ⇒ Do not exercise
I d-node: 9.32 < 10 ⇒ Exercise
I Since early exercise is optimal at the d-node, we need to replace 9.32 by 10
I Initial node: Price of the put is
(0.375 × 0.62) + (0.625 × 10)
P= = 6.45 .
1 + 1.25%
(RNP of an up move is 0.375)
6.45 > 5 ⇒ Do not exercise
It may be optimal to exercise an American put prior to maturity
Hence, the price of an American put may be greater than the price of the
corresponding European put
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Early Exercise of an American Call - Revisited

If the underlying pays dividends, then exercising an American call is optimal

at maturity
just before a dividend payment

Intuition:

By exercising at 1 instead of 2 we
lose the interest, lose the right not to exercise (option to wait)
gain nothing (no dividends between 1 and 2)
→ always better off exercising at 2, or at maturity. Exercising at 1 cannot be
optimal
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Early Exercise of an American Call - Revisited

By exercising at 3 instead of 2 we
lose the dividend
gain almost nothing (very little interest between 2 and 3)
→ always better off exercising at 2, or at maturity. Exercising at 3 cannot be
optimal

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Exotic Options

European and American calls and puts are called plain vanilla options
Options with more complicated payoffs are called exotic options
An important class of exotic options are path-dependent options. Here are
some examples
I Lookback call: the option to buy the underlying asset at the minimum price
which the asset reaches during the life of the option. Payoff is [ST − Smin ]+ .
I Average strike Asian call: the option to buy the underlying asset at the
average price of the asset during the life of the option. Payoff is [ST − Save ]+ .
I Average price Asian call: Payoff is [Save − K ]+ .
To value such an option, one has to keep track of the whole price path of the
underlying asset
This requires a non-recombining tree, where each end node corresponds to a
sequence of “up” and “down” moves

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Non-Recombining Binomial Trees

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Pricing a Lookback Call

Calculate the price of an option which, at the end of the third period, gives its
holder the right to purchase the underlying asset at the minimum price realized
over the life of the option → lookback option

Binomial model with u = 1.2, d = 0.9, r = 10%, S = 100, T = 3

1.1−0.9 2
Risk-neutral probabilities: q = 1.2−0.9 = 3

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Pricing a Lookback Call

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Pricing a Lookback Call

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Asian Options

The payoff of an Asian option is based on the average price over some period
of time → path-dependent
Situations where Asians options are useful
I When a business cares about the average exchange rate over time
I When a single price at a point in time might be subject to manipulation
I When price swings are frequent due to thin markets
Asian options are less valuable than otherwise equivalent ordinary options,
since the average price of the underlying asset is less volatile than the asset
price itself

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Asian Options

There are 8 basic kinds of Asian options:

I Put or call
I Geometric or arithmetic average
I Average asset price is used in place of underlying price or the strike price
Arithmetic vs geometric average
I Suppose we record the stock price
P every h periods from t = 0 to t = T
I Arithmetic average: A(T ) = N1 N i=1 Sih
1
I Geometric average: G (T ) = (Sh × S2h × ... × SNh ) N
Average used as the asset price: Average (geometric) price option → payoff
average price call = max[0, G (T ) − K ]
Average used as the strike price: Average (geometric) strike option → payoff
average strike call = max[0, ST − G (T )]

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Barrier Options

The payoff depends on whether over the option life the underlying price
reaches a specified level, called the barrier
I path-dependent
I since barrier puts and calls never pay more than standard puts and calls, they
are no more expensive than standard puts and calls
I widely used in practice

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Barrier Options

Barrier puts and calls

Knock-out options: go out of existence if barrier is reached
Knock-in options: come into existence if barrier is reached
Important parity relation for barrier options:
knock-in option + knock-out option = ordinary option
Rebate options: make a fixed payment if the asset price reaches the barrier

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Compound Options

An option to buy an option

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Gap Options

A gap call option pays S − K1 when S > K2 and K1 < K2

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Gap Options

A gap put option pays K1 − S when K2 > S and K1 < K2

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Conclusions

The binomial tree is useful also for pricing American or other exotic,
path-dependent derivatives.
However, the tree has to be non-recombining
Exotic options include
Lookback options
Asian options
Barrier options
Compound options
Gap otpions

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